Bond Strategists Ponder Fed Policy Error as Market Gauges Tumble

A day after the Federal Reserve’s third rate hike in six months, fixed-income strategists digesting the bond market’s signals are beginning to invoke the two words central bank officials dread: policy error.

Anticipated inflation is the root of their concern, after Wednesday’s consumer price index data missed estimates. Forward expectations for price growth gauged by CPI-linked Treasuries are sliding, the gap between short- and long-term yields is the smallest in almost a year, and the overall shape of the curve implies traders see the 10-year yield at less than 3 percent five years from now.

“The fact that the Fed is tightening against the backdrop of slowing inflation implies that the market continues to price in policy error,” Jabaz Mathai, head of U.S. rates strategy at Citigroup Inc., said in a note.

Citi forecasts that 10-year and 30-year Treasury yields will remain close to current levels at year-end. That’s even as the two-year yield continues to climb as the Fed is expected to raise rates again in the second half of 2017.

Under that backdrop, the Treasury curve will flatten even more than it already has, setting a new low for the past decade. For now, the yield spread between the two- and 30-year maturities fell to about 143 basis points, approaching the nearly nine-year low set in August.

Measures of the yield curve broadly flattened Wednesday after the Fed lifted policy rates by 0.25 percentage point and also detailed a plan of how it will slowly unwind its near $4.5 trillion balance sheet of debt holdings — saying it may start this year. Traders only see about a 17 percent probability of a September hike, even though officials left their median projections for the path of rates unchanged for 2017 and 2018. Odds of a December hike are about 28 percent.

Chair Janet Yellen, in her press conference Wednesday, and officials quarterly projections again showed expectations the recent slowing of inflation growth is likely to be transitory — not something all market participants agree on. Strategists at Bank of America Merrill Lynch warned this week that falling oil and commodity prices may suggest that the Fed is “sleepwalking” into a policy mistake by tightening policy in a way that may derail economic growth.

Data released Wednesday showed that on a year-over-year basis, the core version of consumer price inflation, which strips out food and energy components, slowed for the fourth straight month, to 1.7 percent in May.

This all signals to some market observers that the models the Fed is using to drive policy decisions may be broken. If the Fed retains that framework and inflation continues to fall as labor slack eases, then traders may ratchet up the message that the Fed is going off the rails.

Based on the last time the Fed raised rates, from June 2004 to June 2006, traders should expect the yield curve to flatten. After all, the spread between five- and 30-year U.S. debt flattened to eight basis points from 147 basis points over that period.

Yet since the central bank boosted its benchmark in December, that yield spread narrowed by about 20 basis points, to 103 basis points. By contrast, after the first three rate hikes of 2004, the curve was little changed at 149 basis points.

While not entirely conclusive, it does signal that the market’s expectations for subdued inflation relative to the Fed means the Treasury curve is flatter than it may otherwise be at this point in the central bank’s normalization process.

The 10-year breakeven rate, the yield spread between 10-year U.S. Treasuries and similar-maturity Treasury Inflation Protected Securities, or TIPS, is 1.69 percentage point, the lowest since November and in line with the declining core CPI figure from the Labor Department.

“The Fed’s current stance has been perceived as overly hawkish relative to the inflation outlook,” wrote Matthew Hornbach and Guneet Dhingra of Morgan Stanley in a note. “And until better data is forthcoming, we think the Treasury market will continue to trade as if the Fed is making a policy error.”